How old bonds can fund new goals

Anne McClean looks at how old policies that have been languishing at the bottom of a drawer for years may help support the financial priorities that matter to you today.

“Bond” is a term used interchangeably in financial services to describe a number of products, so it is always a useful exercise to clarify which type is being discussed. The term could refer to a fixed-rate savings bond, which is basically cash savings, or it could be a government or corporate bond, which are part of the fixed income asset class. It may also refer to an investment bond, which is a type of tax wrapper, similar to an ISA or pension, that can be held either onshore or offshore. In this article I am concerned with the latter – investment bonds.

I often come across clients with these policies languishing forgotten in a back drawer. They were often purchased from a bank many years ago – or perhaps from the Man from the Pru (other brands are available). They may have been recommended to higher-rate taxpayers as a tax-efficient vehicle for long-term investment, or they may have been used for estate planning purposes.

The biggest misconception I come across is that investment bonds are tax free. This is certainly not the case.

Any gain realised on an investment bond may ultimately be subject to income tax. However, you are generally able to withdraw up to 5% of the original investment each year without an immediate tax consequence. These withdrawals are treated as a return of capital and are effectively deferred until a chargeable event occurs. This feature is one reason bonds are often used in trust planning, as there is no requirement to report these withdrawals annually on a trust tax return.

The real beauty of investment bonds is twofold:

• You are able to choose the timing of the tax event and, with some thought and care, potentially mitigate the tax liability altogether.
• You are able to transfer the tax liability to another person without triggering an immediate tax charge.

With careful planning, this can mean more money reaching the people who matter most to you.

For example, Felicity wishes to help fund school fees for her grandson, Tom. She assigns an appropriate proportion of her investment bond into a bare trust for Tom, who is just about to start prep school. Tom has no income of his own and therefore has his full personal allowance available. When the bond is eventually encashed, the gain is assessed on Tom rather than Felicity, potentially resulting in little or no tax being payable. By using the bond in this way, more of the underlying value can be directed towards funding his education.

Investment bonds are often used alongside trusts as part of estate planning. There are four main structures:

Depending on the trust structure, some or all of the value may fall outside the estate for inheritance tax purposes, either immediately or after seven years. However, any gains realised within an investment bond are generally subject to income tax rather than capital gains tax. This is worth reviewing regularly. In some cases, assigning bond segments to beneficiaries before encashment can produce a more favourable outcome than allowing trustees to trigger the tax charge themselves. As with any investment, it is important to understand how the arrangement supports your wider objectives.

For example, one of my clients was widowed and, when I first met her ten years ago, we wanted to begin planning for a potential inheritance tax liability. At the time she was not in a position to make outright gifts from her assets, so we established a loan trust.

A loan trust allows a sum of money to be lent to a trust while allowing future growth to accrue outside the lender’s estate. The original loan remains repayable to the person who established the trust and can be recalled at any time.

Her children are now in their early twenties and beginning their careers, and she wanted to help them onto the property ladder. The first step was establishing that such a gift was genuinely affordable. Rather than simply withdrawing money from ISAs and other investments, we reviewed her overall position.

After reviewing her circumstances, she decided to forgive the outstanding loan to the trust, starting the seven-year inheritance tax clock, and to wind up the trust at the same time. By passing the eventual income tax liability to her children, who had lower taxable incomes, we were able to avoid the tax liability altogether. As a result, a greater proportion of the family’s wealth was available to support their property purchases.

Investment bonds can be surprisingly flexible planning tools, particularly where family support, retirement income or inheritance tax planning are concerned. However, their value often lies not in the bond itself but in how it fits within your wider financial arrangements.

If you have an investment bond that has not been reviewed for some time, it may be worth revisiting it. A review can help determine whether it is still serving the purpose it was originally intended for, and whether it can be better aligned with your current objectives.

This is issued by IPS Capital LLP of 4 Eastcheap, London EC3M 1AE; a limited Liability Partnership registered in England OC328405 and authorised and regulated by the Financial Conduct Authority.   It is issued in the UK only. This publication does not constitute advice and is for information purposes only. You should not make any investment decision based on this information alone. The information contained herein is correct to the best of our knowledge and we may not be held liable for any errors or omissions. IPS Capital LLP does not offer tax advice and you should seek professional tax advice for your own circumstances. The value of investments can fall as well as rise and you may not receive back the full amount of your original capital.